When you start a business, one of the first things you must do is decide on a legal structure. Usually you’ll choose either a sole proprietorship, partnership, limited liability company (LLC) or corporation.
Each of these has advantages and disadvantages and we’ve provided some basic business structure information that may be of assistance in making your decision. You should discuss various options with a legal representative or accountant who is knowledgeable in these areas.
There are many reasons to incorporate and thereby, run business processes or hold assets under a corporate umbrella. These include;
- liability protection,
- financial privacy,
- lower taxes,
- business management flexibility,
- increased capital for growth.
Which is “best” depends on your particular circumstance and objective. You should understand how each legal structure works and then pick the one that best suits your needs.
A corporation is a form of business created according to the laws of a specific state or country. You cannot create an entity simply by an agreement as you can with a partnership. You need the authority of the government. This allows the advantages of incorporation and taxation to take place. Under the law, a corporation is treated as a separate person. This is part of the “Corporate Veil” which supports the notion of liability protection and separation of owners and corporate entity.
The main feature of LLC’s and corporations that attracts small businesses is the limit they provide on their owners’ personal liability for business debts and court judgments against the business. Another factor might be income taxes: You can set up an LLC or a corporation in a way that lets you take advantage of more favorable tax rates. In certain circumstances, your business may be able to stash away earnings at a relatively low tax rate. In addition, an LLC or corporation may be able to provide a range of fringe benefits to employees (including the owners) and deduct the cost as a business expense.
We have listed the more common entity options and highlighted some of the elements of each including examples of the strengths and weaknesses.
The list is not exhaustive and is for information purposes only. This article is not to be construed as the giving of a legal opinion or tax advice.
“C” Corporations
A corporation is a separate legal entity that exists independently from its owners. A corporation is created and comes into existence when articles of incorporation (charter or certificate of incorporation in certain states) are filed with and accepted by the proper state authority.
A corporation generally provides greater flexibility than other business entities in areas such as financial privacy, tax treatment, business deductions, retirement options, ownership and management.
There are two types of corporations—a regular (or C) corporation and an S corporation. There are some similarities, but there are some very important differences. Both start out the same way under state law. That is, you file incorporation papers with your state. After incorporating, you can decide whether to remain a C corporation or elect S corporation status for tax purposes.
What is the Structure of a Corporation?
A corporation is owned by stockholders. While stockholders do not directly manage the corporation, they influence corporate decisions through indirect actions such as electing and removing directors, approving or disapproving amendments to the articles of incorporation and voting on important corporate decisions.
The members of the Board of Directors are responsible for managing the affairs of the corporation. Usually, directors make only major business decisions, however they supervise and appoint officers who make the day-to-day business decisions of the corporation. These Officers are responsible for the everyday management of the corporation.
A stockholder may serve on the Board of Directors and also be an officer of the corporation. In fact, in most states one person is enough to form a corporation, and that person can be the sole officer, director and stockholder.
What are some Advantages of a C Corporation?
Limited liability. This is usually the primary reason for incorporating. And the benefits are the same for both C and S corporations. You should be aware that the limited liability is not absolute. You could still be sued personally for actions for which you re responsible such as misfeasance, malfeasance, and even nonfeasance. You’ve got to be careful to follow the formalities of a corporation; failure to do so could result in a loss of protection (piercing the corporate veil). Finally, many creditors require shareholders of small businesses to personally guarantee loans, leases, lines of credit, etc. These points notwithstanding, a corporation can provide considerable protection.
Free transferability of ownership. If you want to sell your interest in a corporation all you need do is sign the back of the stock certificate. The same is true of taking in a new owner. He writes a check and you issue a stock certificate. In a partnership, limited liability company (LLC) or sole proprietorship adding or changing owners is much more difficult.
Number of owners. A “C” corporation can have an unlimited number of owners. A sole proprietorship can have only one. While there’s no limit on the number of owners in an LLC or partnership, large partnerships or LLC’s can be difficult to manage.
Type of owners. There is no restriction on the type of shareholder. A corporation can be a shareholder, as well as a partnership, trust, individual, etc.
Capital structure. A C corporation has considerable flexibility in its capital structure. In addition to regular common stock it can issue different classes of common (voting or nonvoting), and it can issue preferred stock, bonds, warrants, etc. Advantages for acquiring new capital for the business to grow.
Continuity of life of entity. Shareholders can sell their shares or die and the corporation continues to exist as long as there is one shareholder.
Graduated Tax Rates. A C corporation pays a separate tax at graduated rates, federal (15% on the first $50,000; 25% on the next $25,000; 34% on the next $25,000; special rules apply for income above $100,000). In an S corporation or partnership, the profits and losses are passed through to the owners and reported on their individual tax returns. The advantage here is income retained in the corporation can be taxed at lower rates.
Accounting Methods. A “C” corporation isn’t restricted in its choice of tax year. That is, it can choose to use a fiscal year rather than a calendar year. On the other hand, “C” corporations can’t use the cash method of accounting. An exception is provided for small corporations (annual gross receipts of $5 million or less for the prior 3 years).
Net Operating Losses. Operating losses can be carried back two years to offset income in those years or forward to offset income in future years.
Fringe Benefits. Full business deductions available on fringe benefits for employees, while an S Corporation and other entities have limited amounts available.
Retirement Plans. All types of plans can be structured under the corporation while other entities either do not allow this feature or it is limited in scope.
What are some Disadvantages of a C Corporation?
Dividends taxed twice. The primary disadvantage to incorporation is the possibility of double taxation. The profits of a corporation are taxed twice when the profits are distributed to shareholders as dividends. The dividend is not deductible by the corporation but it is taxable income to you. They are taxed first as income to the corporation, then second as income to the shareholder. However, all reasonable business expenses such as salaries and other operating expenses are deductions against corporate income which can minimize double taxation. Proper planning with a good tax associate can eliminate or reduce this element. Remember that most small corporations never issue dividends but can and do provide benefits in addition to salaries, bonuses, and can provide for a whole range if fringe benefits to the owners like Medical, Dental and Hospitalization insurance
Double Tax on Liquidation. Just like dividends are taxed twice, there is a double tax when a C corporation is liquidated. And, unfortunately, most small to mid-size businesses are sold using an asset sale rather than a stock deal. You might discount the importance of this factor, concentrating on the immediate tax savings. However, the double tax on liquidation can prove extremely costly. It can subject you to a combined tax rate of over 50% just at the federal level. Add state taxes and you could be paying more than 60% of your gain on the sale of the business in taxes. S corporations and partnerships generally avoid the double tax. There is a provision in the law that mitigates the double tax on liquidation, but only slightly. This can still be a major disadvantage of a C corporation. The full impact will depend on your particular situation and the business you’re in. The double tax can hit particularly hard on a business with significant appreciated assets such as equipment, goodwill, customer lists, etc. On the other hand, if you’re a service business and have few assets, this may not be much of a concern.
Long Term Capital Gains. While individual taxpayers pay tax on such gains at only 20%, a corporation could pay tax on a similar gain at 35%. In the case of S corporations and partnerships, such gains are passed through to the owners and taxed at no more than 20% on their individual returns.
Personal Holding Company Tax. A personal holding company is a closely held corporation where a substantial portion of the income consists of interest, dividends, capital gains, royalties, rents, and similar passive income. While most businesses don’t start out that way, you could find yourself in this trap if the operations of the business are sold. There is a tax (at 39.6%) on such income and that tax is on top of the regular corporate income tax.
Accumulated Earnings Tax. C corporations are only allowed to accumulate $250,000 of earnings and profits (similar to retained earnings). Amounts in excess of that are generally subject to tax at 39.6%. You can accumulate higher amounts if you can show a need. While the accumulated earnings tax can be a costly trap for a regular corporation, it can usually be avoided by advance planning. Proving the need to retain additional funds is key.
Personal Service Corporation. Personal service corporations cannot use the graduated rates. Instead, they’re subject to a flat rate of 35% on all taxable income. This rule applies to corporations where substantially all of the stock is held by employees, retired employees, or their estates and the corporation performs services in the fields of health, law, engineering, architecture, accounting, actuarial science, the performing arts, or consulting. If the entity would be labeled a personal service corporation, operating as a C corporation is generally not recommended.
“S” Corporations
An S Corporation is merely a corporation which has elected a special tax status. This tax treatment permits the income of the corporation to be treated like the income of a partnership or sole proprietorship in that the income is “passed through” to the shareholders. Thus, shareholders report the income or loss which is generated by an S Corporation on their individual tax returns. In order to be considered an S Corporation, the stockholders of a properly filed corporation must elect such status within 75 days of formation for the current tax year, or at any time during the preceding tax year. This election is made by filing Form 2553 with the IRS.
What are some Advantages of a S Corporation?
Passthrough of Income and Losses. The big difference between a C and an S corporation is that all the income or losses of the S corporation are passed through to the shareholders and reported on their individual tax returns. This approach generally means that any income is only taxed once. That can produce significant tax savings over a C corporation. There can be material savings during the normal operations of the business, but the biggest savings will come when you want to sell or liquidate the business. When negotiating a sale, the ability to do either a stock or asset deal with little or no tax difference can be significant.
Reduced Tax Rate. Unfortunately, the benefit of the graduated rates available to a C corporation is lost. And, since all the income is passed through to the shareholders, their tax liability can be significant. In fact, it can often require the corporation to make distributions to the shareholders to enable them to pay the taxes.
Losses are also passed through to shareholders. Usually, shareholders can deduct their share of the losses on their personal tax return. That can produce significant, immediate tax savings especially when they’re needed most. There are two major restrictions on the use of the losses. First, the shareholder must materially participate in the business. Generally, that means involved in the day-to-day operations. For most business owners this shouldn’t be a problem. On the other hand, passive investors won’t be able to deduct losses against their other income. They can only be used to offset passive income. Second, a shareholder can only deduct losses up to his basis in the stock and direct loans to the corporation. Your basis is increased by profits and decreased by losses and distributions. Only loans you make directly to the business increase your basis.
Limited Liability. Like a C corporation, an S corporation enjoys limited liability. In fact, for Legal purposes there is no difference.
Free Transferability of Ownership. The rules here are much the same as a C corporation.
Financing the Business. If a shareholder borrows money to purchase an interest in the corporation or provide additional capital, the interest expense is fully deductible by the shareholder. That’s in sharp contrast to a C corporation. Partnerships and sole proprietorships have the same benefits as S corporations.
What are some Disadvantages of a “S” Corporation?
Number of owners. S corporations can have no more than 75 shareholders (a husband and wife count as one shareholder).
Type of owners. Generally, only individuals (must be citizens or resident aliens), estates, and certain types of trusts can be shareholders. Qualified retirement plans and tax exempt organizations can also own stock. The S corporation will be invalidated if an ineligible person owns stock. For example, if a regular corporation purchases one share in the S corporation, the election will be invalid from the date of purchase. Thus, you must be particularly careful that shares don’t fall into the wrong hands.
Single class of stock. While the rules have been liberalized to remove some of the former traps, an S corporation can have only one class of stock. You can have voting and nonvoting common stock, but there can be no difference in liquidation or distribution rights. This requirement can restrict your ability to raise capital.
Accounting methods. An S corporation must generally use a calendar year as its accounting year.
Section 1244. Like regular corporations, S corporation shareholders can deduct up to $100,000 in losses on the stock becoming worthlessness.
Pass through of Income Profits of the corporation must be passed to the owners and taxed immediately at the personal tax rate. This limits the tax planning options.
Complex rules. One of the disadvantages of an S corporation is that there are some complex tax accounting rules. What’s more frustrating is that much of the complexity is unnecessary. For example, charitable contributions are not deductible by the corporation. Instead, they’re shown on each shareholder’s K-I and are deductible by the shareholders on their individual returns. Shareholders who don’t itemize or who have a high AGI and lose some of their deductions, will be at a disadvantage. And, while the contributions aren’t deductible, they do reduce your basis in the S corporation.
Similar rules apply to the Section 179 expense election, payments of shareholders’ personal expenses, etc. Interest, dividends, capital gains, and rental income are also reported separately and increase a shareholder’s basis. This added complexity could increase accounting and tax preparation fees.
The LLC, Limited Liability Company
What is a Limited Liability Company?
A Limited Liability Company (“LLC”) is a separate legal entity that offers an alternative to partnerships and corporations by combining the corporate advantages of limited liability with the partnership advantage of pass-through taxation. An LLC is created and comes into existence when articles of organization are filed with the proscribed fees, and accepted by the proper state authority. An LLC may elect corporate “C” style taxation or pass through taxation like the “S” Corporation
Background of the LLC
In 1977, the US State of Wyoming initiated the first limited liability company act. The revolution gained ground slowly at first, since it took the Internal Revenue Service (IRS) 10 years before recognizing a new hybrid form of business entity which combines the liability shield or protection of a corporation with the federal tax classification of a partnership. The shield protects LLC owners (called members) from personal liability for the business’ debts, and the tax classification provides the advantages of pass-through taxation or corporate style taxation. Today, all of the US states and the District of Columbia have enacted LLC acts.
What is the Structure of an LLC?
An LLC is owned by its members and can be managed by either those members or “managers”. The members of an LLC are like partners in a partnership or shareholders of a corporation.
If the LLC is designated as being managed by its members, then the members will resemble partners because they will have decision-making powers in the LLC.
Alternatively, the members may choose to appoint a manager or managers to act in a capacity similar to a corporation’s board of directors. The managers are in charge of the business affairs of the LLC. A member will then resemble a shareholder because under that situation the members will not participate in the management of the LLC.
A member’s ownership in an LLC is represented by the “membership interest”, in the same manner as a partner has an “interest” in a partnership or a shareholder has stock in corporation.
If managers are not designated in the articles of organization, the members will be deemed to direct the business affairs of the LLC.
What is the Legal Basis of an LLC?
Since LLC’s are creatures of state law, each LLC is organized under a US state enabling statute that (I) creates the company, (2) endows it with a Local existence or juridical personality separate from its members, (3) shields those members from personal liability, (4) governs the company’s operations, and (5) determines how and when the company will come to an end. Although the states’ LLC statutes differ in some respects, all provide LLC owners great latitude to organize their LLC’s in a manner that will be best suited to attaining their business objectives.
What is the LLC Membership and Operating Agreement?
LLC membership may be determined either by the original organizing document of the LLC, which is registered publicly, and/or by the operating agreement of the LLC, which is a private document. The operating agreement typically names the members of the LLC which can be natural or juridical persons along with their proportionate share or interest in the LLC, and sets forth the internal structure of the LLC. Additionally, the LLC may issue “interest certificates” to all the members (similar to shares or stock of a corporation), which certificates will typically bear the name of the LLC, the name of the holder of the certificate, and the proportion or percentage of the interest in the LLC the certificate represents
Because of the recent changes in the federal tax law, operating agreements can now grant LLC’s powers formerly reserved only to corporations. For example, LLC’s can now have perpetual existence, protect the members from personal claims against creditors of the LLC, allow members to transfer their interests freely, and elect managers (or directors) to run the LLC. In addition, like by-laws, operating agreements can allow for the issuance of certificates to members in the LLC with differing or preferential rights with respect to voting and/or the types of distributions they may receive.
What are the Members Official Titles?
In governing an LLC, the members are free to adopt any titles they wish to use. For example, they may call themselves directors or owners. In addition, if managers or officers are to be appointed to direct the affairs of the company, they may assume any titles that the members decide such as President, Secretary, etc.
What are the Main Differences with Corporations and Partnerships?
Prior to the LLC, it was impossible to have both the tax status of a partnership and the liability shield of a corporation. While corporations are distinct juridical persons, providing protection to the shareholders from claims against the corporation, there is a tax cost to doing business through such an entity. In its simplest form, this cost can consist of a double taxation of the corporation’s profits: (1) the corporation is taxed on its profits; (2) the dividends that the corporation distributes to its shareholders on its after-tax earnings and profits are treated as taxable income for such shareholders. Since corporations are considered separate entities from their shareholders, they must submit their own tax return.
Because partnerships ordinarily contain only one or two of the traditional four corporate characteristics (continuity of life, centralized management, free transfer of interests, and limited liability), they are not treated as taxable entities. They thus avoid the double taxation regime governing corporations. Partnership profits pass through to the partners at which level they are taxed alone. Partners can also benefit directly from partnership losses which pass directly through to the partner and can be used as deductions. With a typical corporation, however, losses remain with the entity, and can only be utilized if the entity secures a profit later on. The problem with partnerships, however, is personal liability. In any partnership, at least one partner must be liable for the partnerships debts.
The LLC eliminates the problems of double taxation and personal liability. Prior to the 1997 implementation of the IRS’s “check the box” regulations, the LLC, in order to receive partnership tax treatment, had to be structured so that it contained at most two of the four traditional corporate characteristics. However, because of the new regulations, the LLC will be treated as a partnership either by election (checking the appropriate box) or default (in this case the LLC must have at least two members), regardless of how it is structured. Other advantages of the LLC are that the number and type of its owners is unrestricted. They may be non-resident aliens, corporations, partnerships, individuals, trusts, foundations and estates. LLC’s allow more than one class of “membership interest” (similar to stock) and thus allow for flexible structuring.
What are the Advantages of an LLC?
- Pass-Through Taxation. LLC’s allow for pass-through taxation, allowing earnings of an LLC to be taxed only once. The earnings from an LLC are treated in a similar manner as earnings from a partnership, sole proprietorship and most S corporation.
- Limited Liability. The member’s liability is generally limited to the amount of money which the member invested in the LLC. As a result, the members of an LLC receive the same limited liability protection as do shareholders of a corporation.
- Flexible Organizational Structure. LLC’s are generally free to establish any organizational structure agreed upon by its members. Thus, profit interests may be separated from voting interests. Ie someone can have a large ownership but little attribution of profits and vice-versa
What are the Disadvantages of an LLC?
- Possibility of losing pass-through taxation if the LLC is not properly structured.
- More paperwork than an ordinary partnership.
Limited liability companies, or LLC’s, are a relatively new addition to the list of entity choices. Under state law an owner in an LLG has the same limited liability as a shareholder in a corporation. But, unlike a corporation, partnership, etc. how an LLC is taxed will depend on several factors. If the LLC has only one owner, it can elect to be taxed as a regular corporation or as a sole proprietorship. If there is more than one owner, it can elect to be taxed as a regular corporation or as a partnership. In some cases the decision on the form of taxation will be made for the LLC. In general, the tax advantages and disadvantages of an LLC will follow the way the entity is taxed. For example, if the LLC has a several owners (members) and elects to be taxed as a partnership, it will file a partnership tax return and the partnership tax rules will apply.
How many people are needed to form an LLC?
States vary, and some have required at least two, but recently most states have changed their own rules and allow one member LLC’s.
Should I choose an LLC or an S Corporation?
The status of an S Corporation provides the elimination of double taxation. However, the S Corporation does not have the flexibility of an LLC in regard to the allocation of income to its members.
An LLC may have an unlimited number of members. However, ownership in an S Corporation is limited to no more than 75 shareholders. Further, an S Corporation cannot have shareholders who are C Corporations, other S Corporations, certain trusts, LLC’s, partnerships or nonresident aliens.
LLC’s are permitted to own subsidiaries without restriction, while S Corporations are not allowed to own 80% or more of another corporation’s shares.
How can I structure an LLC to achieve pass-through taxation?
Do not designate Corporate Style Taxation on IRS 8832. Pass-through is the default for a limited liability company in the absence of any other specific designation.
Taxation of LLC’s
One owner LLC’s are treated the same as sole proprietorships. Profits are reported on Schedule C as part of your individual 1040 tax return. Self-employment taxes on LLC net income must be paid just as you would with any self-employment business.
Multiple owner LLC’s are treated as a partnership by the IRS. The tax return that the LLC completes and files is IRS Form 1065, Partnership Information Return. On this form, LLC profits are reported and allocated to each of the owners according to the LLC’s operating agreement. Each owner is given a Schedule K-1, which shows each owner’s share of LLC income or loss. The owner then reports and pays taxes on this income on the owner’s annual 1040 income tax return.
Please note that as with a sole proprietorship, all profits of the LLC are taxed to the owners, even if they are not actually distributed by the LLC. This situation could happen when the LLC needs to use its profits to meet ongoing expenses.
There is a possible third tax treatment that an LLC could elect if it did not want pass-through taxation. The LLC may elect to be taxed as a corporation by completing IRS Form 8832 and checking the corporate income tax treatment box. After making this election, the LLC is taxed as a C corporation by the federal government. Because the corporate income tax rates for the first $75,000 of corporate taxable income are lower than the individual income tax rates that apply to the taxable income of non-corporate taxpayers, it is possible a net income tax savings can result from this tax election.
The state income tax treatment of LLC profits typically mirrors the IRS tax treatment as discussed above. Some states have different rules and for specific information on your state rules visit your state’s web site.
The LLC will have limited liability, and if the LLC is managed by managers, the LLC will have centralized management.
Partnerships
What is a Partnership?
General Partnerships are formed with an agreement between two or more persons. They are the co-owners of the assets and liabilities of the business. Once you form a Partnership, it has its own identity and can conduct business, own property, make contracts.
How are they Taxed?
Much like a S Corporation, they don’t pay a separate tax as all the income and losses are passed through to the partners and reported on their individual tax returns (like a Sole Proprietorship). Partners can deduct losses up to their basis in the partnership. Like S corporations, in order to deduct the losses against regular income the partners must materially participate in the business and can only deduct losses up to their basis. Unlike S corporations, owners are liable for the debts of the partnership. There’s an exception for limited partnerships (see below).
What are the Major Structural Items in a Partnership?
Liability. The partners in a partnership are generally jointly and severally liable for the debts of the partnership. That means a creditor can go after all the partners, or just the one he thinks has the money. That can be particularly disadvantageous if you re the partner with deep pockets. In some cases you may be able to circumvent the problem with insurance.
Free transferability and continuity of life. Transferring partnership interests can be complex and require approval of the other partners. Moreover, in most cases a partnership is usually dissolved on the death, insanity, bankruptcy, retirement, resignation, or expulsion of a general partner.
Number and type of owners. There is no restriction on the number or type of owners. However, from a practical matter, partnerships with a large number of partners can be difficult to manage.
Capital structure. There is considerable flexibility in financing a partnership. In fact, one of the advantages is that loans to the partnership from a third party for which a partner is liable will increase a partner’s basis. That’s in contrast to an S corporation where only amounts loaned directly from a shareholder to the corporation increase the shareholder’s basis. No double tax. Like an S corporation, a partnership escapes any double tax on either regular distributions or liquidation.
Compensation. Unreasonable compensation isn’t an issue for partnerships. In fact, a partner is not considered an employee. Instead, he’s considered self-employed and pays the self-employment tax (similar to FICA, but here the partner pays both parts at 15.3%) on all earnings. Compared to an S corporation, that can add several thousand dollars a year in taxes.
Fringe Benefits. The same restrictions on fringe benefits, including pension plans, medical plans and business expenses, that apply to S corporation shareholders apply to partners in a partnership. In addition, partners may not be able to contribute as much to their pension plans as S corporation shareholders.
Accounting methods. Many of the same accounting method restrictions that apply to S corporations apply to partnerships.
Capital gain on sale. On the sale of your interest, part or all of the gain may be taxed at ordinary income rates.
Organization. While organizing a corporation can be very straightforward, drafting a partnership agreement can be very involved. Moreover, a well drafted agreement can be vital to the operation of the entity.
Real estate and joint ventures. For many types of operations, you must carefully evaluate the pros and cons of using a partnership. There are, however, two situations well suited to a partnership. The first is a real estate venture. Here the liability issue is usually small and can be handled by insurance. Moreover, most real estate operations are highly leveraged with outside debt. The fact that such debt will be added to a partner’s basis (if he’s responsible), is a big advantage over an S corporation. The second is in the case of a joint venture. Usually this involves two or more entities, often corporations, pooling their efforts for a particular project. The unlimited liability of a partnership is not an issue since the partners are usually corporations. And the ability to make special allocations of income, expenses, etc. can produce significant tax advantages for the participants.
Limited Partnerships
Limited partnerships are a variation on the general partnership discussed above. In a limited partnership there are one or more limited partners and at least one general partner. Limited partnerships are usually created by filing forms and fees to the state and establishing a formal partnership agreement following state law. This agreement is a Legal document that specifically details powers and responsibilities of each partner and how the partnership will function.
Limited Partnerships are commonly used where asset protection strategies and especially when real estate assets are involved. The limited partners have neither liability for business activities nor management responsibilities. The limited partners can’t lose more than their investment. The general partner has unlimited liability. The general partner can (and should) be a corporation, thus limiting its liability.
Limited partners are restricted in their deduction for losses, usually up to the amount of their investment. A major advantage is that personal creditors cannot seize assets nor force the sale of a partnership interest.